Microsoft finally called it quits and walked away from the offer to purchase Yahoo at $31 per share on a half-stock half-cash basis. The deal originally valued Yahoo at almost seven times sales and over 65 times earnings. The offer price was 60% over what Yahoo was trading the previous day and was exceptional given that analysts expect Yahoo to grow earnings at 20% in the coming years. This premium reflected Microsoft’s desperation for market share in the Internet space.

Both Microsoft and Yahoo erred in their judgment of each other’s reaction to the renewed offer. Microsoft anticipated any negotiation will be for an all-cash deal as opposed to a higher price from the Yahoo board – Jerry Young the founder, and big holders of Yahoo stock such as Capital Research and Legg Mason. Yahoo’s board on their part assumed Microsoft to easily increase the offer price by 10-15% given the resources they have. The mentality of the Yahoo board was delusional in that they failed to recognize that the offer price was steep by any measure and there was no way to justify a higher price for Yahoo. By focusing on what Microsoft could afford, rather than what they were worth, the Yahoo board failed their fiduciary responsibility to Yahoo shareholders.

In hindsight, the deal would probably have gone through easily at around $30 a share, had Microsoft sweetened the offer with a premium of about 30% initially and shown a willingness to up the bid significantly in exchange for co-operation from the Yahoo board. An approach similar to what Larry Ellison at Oracle did with People Soft, where they reduced the initial offer significantly in response to push-back from the board, would have resulted in a better outcome.

To summarize, mistakes on both sides were the order of the day with this deal. Both the companies will pay dearly for the distraction in the short-term. Over the long term, walking away should do well for Microsoft shareholders as their management gets a chance to steer the ship in the right direction.